Wednesday, April 11, 2012

"The market for forward volatility has become unhinged" (VIX; VXX; TVIX)

That would have been the quote of the day but for the fact the whole darn piece is worth a read.
From FT Alphaville:

When the tail-event becomes the standard risk

If anyone can bring metaphor and illustration to the market in volatility, it’s Chris Cole at Artemis Captial Management, a volatility-focused investment firm.
Take the intro of his latest note as an example:

Imagine the world economy as an armada of ships passing
through a narrow and dangerous strait leading to the sea of prosperity.
Navigating the channel is treacherous for to err too far to one side and
your ship plunges off the waterfall of deflation but too close to the
other and it burns in the hellfire of inflation.
—-
Today the existential fear of world’s end deflation is so powerful
investors are willing to pay the highest prices for portfolio insurance
in nearly two decades. The market for forward volatility has
become unhinged as the SPX variance and VIX futures curves sustain
historically high premiums over low spot vol.

My argument is not that this extreme fear is misplaced but that it is mispriced.Like Odysseus in the epic poem the global economy is trapped between the monsters of Scylla and Charybdis. We risk one to avoid the other. From
one world’s end to the next sometimes I wonder if decades from now we
will look back with the hindsight that we were all hedging the wrong
tail.

Cole has been arguing for a while that the injection of huge amounts
of QE-money into the system — the equivalent of a giant put option –
has undoubtedly had an impact on volatility markets, and most likely in
ways we don’t really understand. Yet.

For one thing, Cole observes that since early 2009 volatility spikes
have consistently occurred shortly after the end of central bank balance
sheet expansion. “The greater the level of monetary expansion the
calmer the Vix and the higher the gains in the S&P 500 index (and
vice versa). Volatility markets know this and that game theory
expectation has contributed to the steepest SPX volatility curves in
over two decades.”...MUCH MORE